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June 10, 2008

Federal Charters for Accounting Firms -- A Blank Page Approach

Six years on from the disintegration of the Arthur Andersen firm, the fragility of the last Big Four and their franchise to provide large-company audits attracts a discussion that is steadily louder – but not more productive.

The latest example of a collection of the wise, talking past each other, was the June 3 meeting of the US Treasury’s Advisory Committee on the Audit Profession, summarized on Edith Orenstein’s blog – here – and webcast here.

A reason the discourse is so barren is the circularity of the blame-mongering. Rather than recognize the interlocking web of entanglements, the focus is on the problems of “the other guys.” The list includes:

• Issuers’ incentives to manipulate their results• Overly complex accounting standards• Persistently inadequate audit performance by a too-small oligopoly• Regulators with over-lapping but parochial interests• Liability standards that lack precision in practice or predictability in outcomes, and • The overhang of catastrophe-level litigation that would overwhelm the audit firms’ fragile capital structures.

If there is ever to be a comprehensive, holistic solution, a blank-page approach is essential. There is such a framework at hand – although it would require a clean, robust and full-blown debate and a fresh legislative mandate. What is lacking, but essential in the organizational and legislative discussion, is the broad buy-in and ready participation that might actually replace today’s antagonistic finger-pointing.

Namely, national-level “charters” or “public company audit licenses” – the naming is less important than the concept – could authorize and regulate newly organized and re-structured firms -- that would do the audits of all public companies.

Applied in the United States – a jurisdiction necessary for any worldwide solution -- a new system would be administered by the Securities and Exchange Commission and the Public Company Accounting Oversight Board, having as analogies the government oversight of American stock exchanges, credit rating agencies and broker-dealers.

Newly organized “public company audit licensees” could be in corporate form. They could be owned by existing accounting networks or other new market entrants. Their resources – personnel, methodologies and technology – could be internal, or out-sourced from the existing Big Four or from emergent niche competitors.

For quality and enforcement purposes, audit engagement personnel would be individually licensed along with their employers, in coordination between federal authorities and existing state regulations over education, examination and training.

Minimum capital requirements could be set, geared to the firms’ turnover or the capitalization of their client list. Governance structures could include independent outside directors, and accountability of management to agency oversight – measures not presently achievable under the constraints of state regulation and the laws of partnership and bankruptcy.

Collateral benefits to federal “chartering” abound:

Because these SEC licensees would be “audit only” enterprises, the multiple overlapping restrictions on scope of services would be finessed, and the endless debate over independence and permissible ancillary services could at last be ended.

Associated non-audit entities – whether parent or affiliate companies – would be freed from independence and compliance requirements, able to evolve beyond the one-page statutory report that now looks so obsolete. Targeted assurance reports could be designed that users in the capital markets would actually value and pay for. Immediate examples ripe for attention would have been Shell’s petroleum reserving, the internal trading controls regime at Société Générale, and the black hole of inter-company money transfers at Parmalat.

In aide of enhanced competition and expanded auditor choice, segments of the public company market could be specifically identified to encourage new entrants – such as high-risk or technically specialized sectors (IPO’s, troubled companies and financial services come to mind) – whose audits could be segregated, underwritten and priced as now done with high-risk insureds.

Under the aegis of the licensees’ regulators, a privileged forum could be organized to scrutinize cases of accounting and audit insufficiency for lessons and areas for improvement – drawing for experience on the airline, engineering and medical models for the successful study of failure.

As to liability -- the elephant in the room – and taking at their word the investor advocates who would prefer improved information over the capricious and low-return litigation lottery: the investigation and prosecution of all auditor claims based on public company financial statements would be pre-empted into the hands of the supervising agency. A specialized tribunal of expert jurists would hear all cases, levying fines and sanctions against convicted wrongdoers, both firms and individuals.

Compensation for legitimately damaged investors would be determined through the agency process rather than the caprice of juries and settlements, and be funded through a system of fee schedules rather than the hazards of limited firm capital.

Modifications of existing regimes would include elimination of the tax code’s incentives to maximize distribution of current revenues, and a cut-off above which audit firms would not audit their own owner/investors.

And with firewalls of corporate organization and bankruptcy infrastructure in place to limit liability, the conditions for insurability could be brought once more into alignment with manageable litigation and enforcement risk.

With this array of stabilizing governance changes in place, the new structures could at last be attractive to outside capital, which would be needed by offerors of new services in order to fund the necessary research, personnel and technology.

Given the dead-end nature of the debate these last years, the bare bones of this proposal should include something to excite or insult nearly everyone – which could be a signal that it is broad enough to be worthy of pursuit.